June Swoon Ahead? Maybe, But Not Because Of Valuations

Given the recent extraordinary performance of most equity markets, many investors are wondering whether the bull market has run its course. Russ explains why valuation alone doesn't signal an imminent correction.

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Earlier this week, the S&P 500 reached an all-time closing high, and U.S. equities aren’t the only ones hovering around record highs. On a global basis, stocks have advanced more than 40% since the summer of 2012.

Given the extraordinary performance of most equity markets and the percentage of gains driven by expanding multiples, it’s not surprising that many investors are wondering whether the bull market has run its course and a June swoon is on the horizon.

My take: While there are few absolute bargains left anywhere in the equity market and stocks are no longer cheap at the aggregate level, equities at the broad level aren’t so stretched as to suggest that valuation alone is likely to end the bull market.

As I write in my latest Market Perspectives paper, “Has the Bull Market Run Its Course,” although a number of valuation metrics today suggest lower returns over the next five years than enjoyed over the previous five, global valuations are neither indicative of a market top nor at a point that would suggest aggressively lowering equity allocations.

U.S. large cap valuations, for instance, as measured by the price-to-earnings ratio of the S&P 500 index, are above their long-term average, but not obscenely so.

In addition, the overall macro environment – one of low inflation, low interest rates and accelerating growth– is a favourable one for stocks and is supportive of modestly higher valuations. Historically, investors have paid more for a dollar of earnings when inflation is lower. Nor is the prospect of rising rates a significant threat, at least not at these levels. When yields are below 4.5%, as they are today and should be through at least early next year, multiples actually tend to rise along with rates.

It is true that other metrics paint a more negative picture. The Shiller P/E ratio, a cyclically adjusted price-to-earnings (CAPE) ratio, suggests U.S. stock valuations are unambiguously expensive. However, today’s levels are not yet in the nosebleed territory that characterized the 2000 Internet bubble stocks and aren’t yet at a level that suggests negative returns over the long term.

Most importantly, valuations look more reasonable when you take a global perspective. The United States appears the most expensive of the major markets. CAPE valuations are much closer to average for other equity markets. While none of the other markets, with the possible exception of Japan, are at a particularly cheap level, valuations look like much less of an impediment than they are in the United States.

To be sure, either an exogenous shock or a sharp spike in interest rates would change the fundamentals and probably lead to a sharp correction, if not an outright bear market. However, I don’t expect either to occur. In fact, I expect equity markets to finish 2014 modestly higher.

But while I don’t foresee a market correction in the near term, there are a number of areas of the equity market that look overvalued and toward which investors will want to exercise caution, including growth stocks – particularly in the biotech and social media sectors – and U.S. small caps.

At the same time, there are pockets of relative value that investors may want to raise exposure to, notably the Japanese market, U.S. value stocks and, to a lesser extent, European and emerging market equities.

Sources: BlackRock, Bloomberg

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries.

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